A Realistic Look at Restaurants: Q&A with Jeremy Scott

We spoke with Mizuho restaurants and proteins analyst Jeremy Scott, who initiated coverage on ten stocks spanning the protein, fast casual, fast food and café sectors in June. He shares his insight on where the industry is headed, what investors should look for and why the survival of fast food may be more likely than you think.

Question:What are the main themes in the protein and restaurant industries?

Answer: I would say supply chain reform (slow grow, antibiotic-free, e.g.) is certainly the biggest theme, and it’s one where we can leverage our cross-sector coverage. For protein, we see it as the biggest risk to supply estimates over the next ten years, whereas for restaurants we see it as a key driver of structural COGS (cost of goods sold) inflation. Mature QSR (quick service restaurants) names are facing new marketing and demographic challenges, and supply chain reform will continue to be a key weapon to stay relevant with younger consumers.

The urgency has been driven by fragmentation, our second key theme, which has been a decade-long trend but it’s really accelerating now due to the emergence of prepared foods in non-traditional channels, such as convenience stores and groceraunts, as well as the growing adoption of online options. Consumers are finding new ways to cheaply and conveniently dine both in and out.

However, that fragmentation has limits. Fast casual concepts are replicating and the product is becoming ubiquitous. When everything is better, fresher and healthier, the disruption plane thins and the messaging loses meaning. At the same time, minimum wage pressures are pushing up menu prices, driving wider gaps between traditional QSR, and challenging traffic. Despite near-term challenges, we see more oxygen for QSR down the road.

Clearly, delivery and mobile adoption is accelerating, and many major chains are still figuring out where they stand and what they can do. There are ongoing debates about: 1) what types of food and beverages are portable, 2) whether delivery is truly incremental to sales and 3) what type of operational challenges come from managing orders originating outside the four walls of the store. However, we think the underappreciated impact of delivery and mobile is that it’s deflationary. An aggregated delivery portal releases the typical friction points that drive pricing power, such as convenience, in-store experience, real estate, etc. A McDonald’s may be the first right turn after a major highway exit, but should it join a delivery aggregator, everyone plays with the same deck of cards.

Q: Is this disruption of food production and distribution a global trend or is it specific to the US?

A: There are major markets where similar things are happening. In China, food delivery has exploded. The Grubhub of China merged with the Groupon of China two years ago, and during that period, we’ve seen unprecedented adoption. It’s proven to be extremely disruptive.

Q: What expectations should investors hold and what market events should they watch for throughout the remainder of 2017?

A: For protein, it’s all about trade in 2017. The NAFTA negotiations are a very big deal. Mexico is a critical relationship for US producers.

For restaurants, we believe we’ll start to see the impact of three years of significant minimum wage hikes on store growth pipelines. These are trying times for franchisees, particularly in coastal markets, and consumers are balking at price increases. We’re also watching minimum wage decisions around the world.

Tax reform, of course, has been back and forth. For QSR restaurants, which depend on the relative low after-tax cost of debt to fund shareholder returns, it’s a mixed bag. A loss of the interest rate deduction, which seemingly has a higher level of GOP support, would significantly alter the economic model and valuation.

Q: Which are your top picks at the moment?

A: To frame it right – I think we’re in a period of rather extraordinary valuations. The multiples on restaurant stocks have risen quite considerably, and relative valuation has bubbled. In aggregate consensus estimates on QSR, the market is looking for system sales acceleration over the next three years. That will be difficult to achieve. I think now more than ever it’s important to pick winners and losers in QSR, and as a result, McDonald’s is the most compelling story to me both in terms of the rate of change, as well their ability to recapture market share through strategic adjustments to their menu, marketing and in-store experience.

In protein, Tyson appears oversold. The company is an early-innings, transformation story. It has been discounted by a prevailing bear thesis that its margins aren’t sustainable, and yet the evolution of the industry and the company is being overlooked.

Q: Is there anything that investors are missing about these industries based on consensus?

A: My concern – and I’m probably one of the most cautious on QSR restaurants – is the indiscriminate buying of refranchising stories. In the short-term, it looks great because it pumps in free cash flow and pulls forward equity. Over the long-term, however, there are consequences to decentralization. At these multiples, the free cash flow ramp has been priced in.

Simon Hylson-Smith

CEO, Paragon

Simon Hylson-Smith is a former financial industry editor and currently CEO of Paragon.